Decentralized finance (DeFi) is admittedly within the regulator’s scrutiny in the US. Unlike the focus on stablecoin issuers and crypto exchanges, US Treasury has yet to portray intent of taking out the DeFi.
The US authority is prioritizing an in-depth understanding of the risks confronted by DeFi. In particular, the authority focuses on assessing the nature of risks that DeFi pose to users and the broader financial system. In its recent report, the Department of Treasury is willing to mitigate the risks while facilitating DeFi operation.
Reasons for Treasury Department Concern for DeFi Projects
Decentralized finance is becoming a significant item on the agenda of various financial regulators, particularly in the US and France. The recent publications from the two countries’ authorities admit analyzing the risks inherent in DeFi projects and how the developers could resolve the concerns.
The inclusion of DeFi within the US authority’s radar is unsurprising given that it is presently a critical constituent of the crypto sector. The reports confess that DeFi scrutiny arises from the recent episodes of exchange implosion and lender bankruptcies such as Voyager Digital and FTX.
Collapse of Crypto-Oriented Banks Necessitate Spotlight on DeFi Projects
It is inevitable for DeFi to confront regulatory focus, particularly with the recent collapse of crypto-oriented banks, including Silvergate Corp., Signature Bank and Silicon Valley Bank.
The destructive nature of the sudden implosion witnessed following the FTX Group collapse in November shines a spotlight on the decentralized projects. A critical concern is how the US regulator can oversee the decentralized entities and services delivered.
The US Department of Treasury replicated the move by the French Central Bank in its April 6 report documenting the assessment of how decentralized finance entities comply with the anti-money laundering regulations. The regulator questioned the vulnerability of DeFi entities in becoming facilitative tools of illicit finance.
Recounting the recent hacks, the US Treasury decries that the occurrence of major hacks in late 2022 reveals the vulnerability of DeFi to attackers. Further, the risk assessment regretted that DeFi entities suffer the possibility of North Korean government-backed perpetrators laundering funds through the channels.
Vulnerability of DeFi to Illicit Finance
The Treasury warns that such occurrences indicated that DeFi projects occasionally failed to comply with the know-your-customer (KYC) requirements. It highlights incidents when DeFi projects contravene the anti-money laundering by facilitating illicit finance.
The US risk assessment report acknowledged that DeFi projects assumed a critical input for cryptos. The Thursday report observed that most DeFi projects deployed open-sourcing in anticipation that the community could spot the vulnerabilities. Nevertheless, open sourcing leaves the projects susceptible to exploitation by attackers.
The US Treasury warns that exploiters can aggravate the vulnerability of DeFi whenever the entities fail to write smart contracts cautiously. The report indicated that compounded risk might occur without a mechanism to quickly deactivate its functioning whenever exploits are identified.
Besides, the risk assessment report urges DeFi entities to prioritize identifying and eliminating vulnerabilities emerging within the open-source code. Nevertheless, the Treasury report portrays neutrality by directing the DeFi entities to reinforce supervisory mechanisms and enforcement actions. Its achievement would guarantee compliance with the legal requirements, particularly by engaging the private-sector stakeholders.
Formulating DeFi-Specific Standards
Meanwhile, the US Treasury assessment aligns with the findings published by the French central bank for the need to formulate DeFi-specific minimum standards. The French regulator signals the need for the guideline on risk assessment and mechanisms utilized when executing financial transactions to private blockchains.
The Treasury Department hinted at replicating the French regulator’s suggestion of formulating certification that DeFi projects developers should meet. It urged the public to suggest how it could ascertain that a particular DeFi project qualifies as a financial institution as outlined in the Bank Secrecy Act.
The assessment completed by the US Treasury Department considered that non-compliance observable in several DeFi services arises from a partial understanding of AML regulations application. The inadequate understanding hinders DeFi project developers from fulfilling the existing AML regulatory obligations.
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